Fed underestimated housing slump

Thursday

May 31, 2007 at 3:49 AM

Federal Reserve officials acknowledged they underestimated the U.S. housing recession, while continuing to view inflation as the biggest risk to the economy.

“The correction of the housing sector was likely to continue to weigh heavily on economic activity through most of this year — somewhat longer than previously expected,” the central bank said in minutes of the May 9 Federal Open Market Committee meeting released yesterday.

Policymakers kept their prediction of a pickup in economic growth and said “downside risks” to the expansion have “diminished slightly.” Inflation that’s too high for officials’ comfort, combined with the housing slump, suggests the Fed may not adjust interest rates in coming months.

The committee foreshadowed that the economy will expand a “little below” the “trend rate of growth through the remainder of this year and then pick up to a rate broadly in line with the economy’s trend rate in 2008.” Many economists and Fed officials estimate the trend rate at about 3 percent.

Treasuries were little changed after the minutes were published. The benchmark 10-year note yielded 4.87 percent at 4:12 p.m. in New York, compared with 4.88 late Tuesday.

Fed officials voted unanimously this month to leave the benchmark U.S. lending rate at 5.25 percent for a seventh meeting. Futures contracts show that traders also expect no change at the June 27-28 gathering.

The Fed kept its statement little changed this month from the previous meeting, updating the economic summary to note that growth slowed and inflation remained elevated.

“It is the first time they have taken such an aggressive posture on housing,” said Anthony Chan, managing director and chief economist at JPMorgan Private Client Services Group in New York and a former Fed economist. “In the past, they have said, in essence, ‘Don’t worry about it.”’

House prices in the U.S. dropped last quarter for the first time in almost 16 years, as 13 out of 20 cities recorded declines in March. A report from S&P/Case-Shiller yesterday showed house prices fell 1.4 percent in the first three months of 2007 from a year before. Sales of existing homes fell 2.6 percent in April to a four-year low, an industry report showed last week.

“They have equally competing forces between housing and inflation,” said David Resler, chief economist at Nomura Securities International Inc. in New York. “When you have higher uncertainly about both outcomes, you stay where you are.”

The minutes contained no reference to a rate cut. Fed officials have consistently warned of the risks of high inflation even as recent readings moderated.

“Nearly all participants viewed core inflation as remaining uncomfortably high and stressed the importance of further moderation,” the minutes said. “Price pressures were not yet viewed as convincingly on a downward trend.”

The Fed’s preferred inflation benchmark, the personal consumption expenditures price index minus food and energy, rose 2.1 percent in the year to March, down from a 2.4 pace in February. The core consumer price index rose 2.3 percent for the year in April, down from 2.5 percent in March.

“Although readings on core inflation in March had been more favorable, this followed several months of elevated inflation data,” the minutes said. “All participants agreed that the risks around the anticipated moderation in inflation were to the upside; and some noted that a failure of inflation to moderate could entail significant costs.”

Gains in the core PCE index have been at or above the top of the comfort range preferred by at least six Fed officials for almost three years. Fed presidents Jeffrey Lacker of Richmond and Michael Moskow of Chicago both warned this month that allowing inflation to drift above 2 percent for a long period could change the public’s sense of how the central bank defines stable prices.

Fed policymakers also noted risks of inflation from external influences. The falling dollar “could reinforce the upward pressure on import prices,” the minutes said. The dollar fell 1.6 percent between the Fed’s two most recent meetings, according to the Fed’s Trade-Weighted Broad Dollar index. The measure yesterday slid to its lowest since 1997.

Robust growth abroad may also “contribute to price pressures at home,” according to concerns expressed by some policy makers at this month’s meeting.

The U.S. economy grew at an annualized pace of 1.3 percent in the first quarter, the slowest in four years and down from the 2.5 percent pace in the previous three months. Residential real estate investment has declined for six quarters, shaving a full percentage point off growth in the first three months of 2007.

Policymakers drew optimism from the outlook for business spending, which “seemed most likely to move higher in coming quarters.” Also, consumer spending would be supported by “continued advances in employment and incomes, as well as gains in stock prices.” Still, advances in wealth and income could be offset by higher gasoline prices, officials noted.

Unemployment at close to the lowest level in five years and gains in stock prices are keeping consumption buoyant. The unemployment rate stood at 4.5 percent in March. The Standard and Poor’s 500 Index is up 7 percent so far this year.

Fed officials continued to view rising defaults and delinquencies in subprime mortgages to borrowers with limited or weak credit histories as an isolated event.

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